"Trading is statistics and time series analysis." This blog details my progress in developing a systematic trading system for use on the futures and forex markets, with discussion of the various indicators and other inputs used in the creation of the system. Also discussed are some of the issues/problems encountered during this development process. Within the blog posts there are links to other web pages that are/have been useful to me.

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Sunday, 6 April 2014

The Cauchy-Schwarz Inequality

In my previous post I said I was looking into my code for the dominant cycle, mostly with a view to either improving my code or perhaps replacing/augmenting it with some other method of calculating the cycle period. To this end I have recently enrolled on a discrete time signals and systems course offered by edx. One of the lectures was about the Cauchy-Schwarz inequality, which is what this post is about.

The basic use I have in mind is to use the inequality to select sections of price history that are most similar to one another and use these as training cases for neural net training. My initial Octave code is given in the code box below:-

After some basic "housekeeping" code to load the price file of interest and normalise the prices, a random section of the price history is selected and then, in a loop, the top N matches in the history are found using the inequality as the metric for matching. A value of 0 means that the price series being compared are orthogonal, and hence as dissimilar to each other as possible, whilst a value of 1 means the opposite. There are two types of matching; the raw price matched with raw price, and a smoothed price matched with smoothed price.

First off, although the above code randomly selects a section of price history to match, I deliberately hand chose a section to match for illustrative purposes in this post. Below is the section

where the section ends at the point where the vertical cursor crosses the price and begins at the high just below the horizontal cursor, for a look back period of 16 bars. For context, here is a zoomed out view.

I chose this section because it represents a "difficult" set of prices, i.e. moving sideways at the end of a retracement and perhaps reacting to a previous low acting as resistance, as well as being in a Fibonacci retracement zone.

The first set of code outputs is this chart

which shows the Cauchy-Schwarz values for the whole range of the price series, with the upper pane being values for the raw price matching and the lower pane being the smoothed price matching. Note that in the code the values are set to zero after the max function has selected the best match and so the spikes down to zero show the points in time where the top N, in this case 10, matches were taken from.

The next chart output shows the the normalised prices that the matching is done against, with the cyan being the original sample (the same in all subplots), the red being the raw price matches and the yellow being the smoothed price matches.

The closest match is the top left subplot, and then reading horizontally and down to the 10th best in the bottom right subplot.

The next plot shows the price matches un-normalised, for the raw price matching, with the original sample being blue,

and next for the smoothed matching,

and finally, side by side for easy visual comparison.

N.b. For all the smoothed plots above, although the matching is done on
smoothed prices, the unsmoothed, raw prices for these matches are
plotted.

After plotting all the above, the code prints to terminal some details thus:

which, column wise, are the Cauchy-Schwarz values for the raw price matching and the smoothed price matching, and the Distance correlation values for the raw price matching and the smoothed price matching respectively.